The Idea:
Global firms that match currency footprints to make profits less variable may in fact lower profits overall.The Research
Nahum Melumad, together with Trevor Harris of Morgan Stanley and Toshi Shibano of Thunderbird, studied how matching currency “footprints” affects a firm’s overall profits. The profits of a firm selling overseas change as the exchange rate changes. One common way of handling such currency risk is to locate manufacturing where the revenues are generated and thereby match the currency footprints. Conventional wisdom suggests that the net result should be lower variation in home currency profits. But what is the effect on total profits?
The study found that matching currency footprints could actually result in lower profit for the firm. Not matching allows for strategic flexibility: a firm with fluctuating costs can better adjust its quantities and prices. When costs are high, the firm can respond optimally by producing and selling less — or vice versa — and so maximize overall profit. The expected profit effect of matching depend on the tradeoff between the possible cost savings of sourcing abroad versus the strategic flexibility to make adjustments in prices and quantities that exploit competitive cost differentials created by exchange rate shifts.
Practical Applications
Financial managers of global firms
The results call into question the practice of matching currency footprints, since it can lower profits and even fail to reduce the variability of profits. Other means of variance reduction may be problematic too: for example, a U.S. firm selling abroad might lock in a foreign currency price for the inputs for any exchange rate as an equivalent to sourcing in the foreign market. Yet this kind of financial instrument cancels out the potential expected profit benefits to the U.S. firm of U.S. sourcing. The U.S. firm may actually have a higher expected profit if it does not convert its cost structure to match its foreign currency-denominated revenues.
Of course, matching currency footprints is desirable in a number of cases: for example, when producing in the country of sale is significantly cheaper, the cost advantage becomes the key determinant of the location of manufacturing. Or when strategic considerations dominate — for example, addressing political sensitivity, taking advantage of tax benefits and circumventing trade restrictions.
Working paper,
2005
Publication type: Working paper
